Tranches: Definition, Risks, and How They Work

Role in the Financial Crisis

tranches
Banks repackaged debt into tranches of bundles they could resell. Photo: Michael A. Keller/Fuse Fuse

Definition: A tranche is a slice of a bundle of loans. It allows you to invest in the portion with similar risks and rewards.Tranche is the French word for slice.

Example That Explains Tranches

Adjustable-rate mortgages have different interest rates throughout the life of the loan. The borrower pays a "teaser" low-interest rates for the first three years and higher rates after that. The risk of default is small during the first three years since the rates are low.

 After that, the risk of default is higher. That's because the rates go up, making it more expensive. Also, many borrowers expect to either sell the house or refinance by the fourth year.

Most banks don't keep the mortgage on their books that long. They resell it on the secondary market as part of a bundle. That's called a mortgage-backed security. Some buyers would rather have the lower risk, and lower rate, while others would rather have the higher rate in return for the greater risk. Banks sliced the securities into tranches to meet these different investor needs. They resold the low-risk years in a low-rate tranche, and the high-risk years in a high-rate tranche. 

History

In the 1970s,  Fannie Mae and Freddie Mac created mortgage-backed securities. First, they bought the loans from the bank. That freed the bank to make more loans and allowed more people to become homeowners.

In 1999, the safe and predictable world of banking changed forever.

Congress repealed the Glass-Steagall Act. Suddenly, banks could own hedge funds and invest in complicated derivatives. As banking became more competitive, those that had the most complex financial products made the most money. They bought out smaller, stodgier banks. Financial services and housing drove U.S. economic growth until 2007.

Despite its name, a mortgage-backed security is not a mortgage on a house that you can see to ascertain its value. It's a financial product whose value is loosely based on the value of the mortgages that backed the security. That value was determined by a computer model.

The college graduates who developed these computer models were known as quant jocks. They wrote the computer programs that determined the value of the mortgage-backed security.

Banks, and quant jocks, were rewarded by making ever-more sophisticated financial products based on ever-more complicated computer models. The quant jocks designed the computer models to break the mortgage-backed security into tranches to take advantage of the different rates offered in an adjustable-rate mortgage. In no time at all, the mortgage-backed securities became so complex that buyers could no longer relate them to the value of the underlying mortgage. Instead, buyers had to rely on their relationship with the bank or hedge fund selling the tranche. The bank relied on the quant jock and the computer model. For more, see What Are Derivatives?

Risks

The computer models priced the tranches based on the assumption that housing prices always went up.

That was a safe assumption until 2006. When the assumption when haywire, so did the tranches, the mortgage-backed security, and the economy.

When housing prices plummeted, no one knew the value of the tranches. It meant no one could price the mortgage-backed security.

The secondary market freed banks from collecting on the mortgages when they become due. They had sold them to other investors. As a result, the banks weren't disciplined in sticking to good lending standards. They made loans to borrowers with poor credit scores. These subprime mortgages were bundled up and resold as part of a high-interest tranche. Investors who wanted more return snapped them up. In the drive to make a high return, they didn't realize there was a good chance the loan wouldn't be repaid. The credit rating agencies, like Standard & Poor's, made things worse.

They rated some of these tranches AAA, even though they had sub-prime mortgages in them.

Investors were also lulled by buying guarantees, called credit default swaps. Reliable insurance companies, like AIG, sold the insurance on the risky tranches just like any other insurance product. But AIG didn't take into account that all the mortgages would go south at the same time. The insurer didn't have the cash on hand to pay off all the credit default swaps. To keep from going bankrupt, it was bailed out by the Federal Reserve.